By David A. Baker
In Commissioner of Internal Revenue v. The Estate of Otis C. Hubert, Deceased, the executors of Mr. Hubert's estate claimed an income tax deduction for the expenses of administering the estate that the executors paid from income earned by the estate after Mr. Hubert's death. The IRS claimed that payment of expenses from income required the estate to reduce the charitable and marital deductions that the executors claimed on the estate tax return on a dollar-for-dollar basis. A divided Tax Court held for the estate, declining to follow authority to the contrary in the Sixth and Federal circuits. The U.S. Court of Appeals for the Eleventh Circuit sustained the Tax Court's decision. The Supreme Court granted the IRS' request for review, and, on March 18, 1997, affirmed the Eleventh Circuit, holding that the Hubert estate was entitled to full marital and charitable estate tax deductions based on date of death values undiminished by the administration expenses charged to accounting income. 65 U.S.L.W. 41883 (1997). The Hubert decision involves an interpretation (some would say an invalidation) of Treas. Reg. 20.2056 (b)-4(a), which provides:
The value, for the purpose of the marital deduction, of any deductible interest which passed from the decedent to his surviving spouse is to be determined as of the date of the decedent's death [unless the estate uses the alternate valuation date]. The marital deduction may be taken only with respect to the net value of any deductible interest which passed from the decedent to his surviving spouse, the same principles being applicable as if the amount of a gift to the spouse were being determined. In determining the value of the interest in property passing to the spouse account must be taken of the effect of any material limitations upon her right to income from the property. An example of a case in which this rule may be applied is a bequest of property in trust for the benefit of the decedent's spouse but the income from the property from the date of the decedent's death until distribution of the property to the trustee is to be used to pay expenses incurred in the admin-istration of the estate.
The Court concluded that this reg- ulation only required an adjustment to the estate tax marital or charitable deduction when expenses charged to income were either "material" or not de minimis. Whether this adjustment will be made in any particular case depends on several factors, including the fiduciary's appetite for tax litigation. This article examines the Hubert decision and explores its ramifications for estate planning lawyers. Although Hubert was a substantial taxpayer victory, practitioners should consider the following before wildly celebrating:
- The Court produced four separate opinions, two (four and three justices, respectively) concurring in affirmance and two (one justice each) concurring in dissent. None of the opinions agreed on when, and under what circumstances, the marital deduction would be reduced for estate administration expenses charged to income.
- The Court did not so much rule for the estate as it ruled against the IRS, throwing out its argument that any payment of administration expenses from accounting income required a dollar-for-dollar reduction in the amount of the estate tax marital and charitable deductions.
- The Court largely decided the case on procedural grounds because the IRS presented no case on the valuation issue that the Court found useful.
- The Court adopted a fact-based test for preserving the full marital and charitable deductions. The two affirming opinions may have applied different standards, and for various reasons the Court provided few guidelines about what facts and circumstances would meet the threshold tests.
- All four opinions assumed as a foundation requirement that the fiduciary has discretion to allocate expenses to post-death accounting income, either under state law or the governing instrument, which may not exist in all cases.
- Even when state law or the governing instrument gives a fiduciary authority to allocate administration expenses to accounting income, the fiduciary could create problems by failing to properly weigh the property law consequences of exercising that discretion.
The facts of Hubert were neither complex nor in controversy. Otis Hubert died in 1986, leaving a gross estate valued at more than $30 million. He left several wills and codicils that were the subject of at least one will contest and related civil litigation. The documents included provisions for his widow and for charity. The Georgia Probate Code and the Georgia Principal and Income Act governed the administration of his estate. The executors had discretion under Georgia law and under the testamentary documents to pay administration expenses from either principal or income earned after the date of death on the principal.
The IRS asserted significant estate tax deficiencies on issues that eventually dropped out of the case. While the initial tax deficiency proceedings were under way, the parties settled the litigation regarding the wills and codicils, agreeing to distribute approximately half of the estate into two trusts for Mr. Hubert's widow's benefit and the other half outright to several charities. The provisions of the marital trusts qualified for the federal estate tax marital deduction under Code 2056, one by a qualified terminable interest property (QTIP) election under Code 2056(b)(7) and one by virtue of the widow's general power of appointment. The settlement agreement preserved the executors' discretion to pay expenses of estate administration, largely attorney fees, from either principal or income. The widow's and the charities' parts shared the burden of those expenses in approximately equal shares. Administration expenses exceeded $2 million. The executors elected to pay over $500,000 of expenses from principal and paid the remaining $1.5 million of expenses from income. Although neither of the lower court opinions are clear on this point, the Supreme Court assumed that the executors deducted the expenses paid from income on the estate's fiduciary income tax return and not on the federal estate tax return.
The Sixth Circuit and the Federal Circuit had previously determined that the payment of administration expenses from marital or charitable income required a dollar-for-dollar reduction in the marital or charitable deduction. Estate of Street, 974 F.2d 723 (6th Cir. 1992); Burke v. United States, 994 F.2d 1576 (Fed. Cir.), cert denied, 510 U.S. 990 (1993). In Hubert, the IRS argued that, under those cases and its regulations and prior rulings, the Hubert estate executors' payment of administration expenses from income required, at a minimum, the reduction of the charitable and marital deductions on a dollar-for-dollar basis. The Tax Court, in a reviewed opinion, held for the estate. 101 T.C. 314 (1993). The Eleventh Circuit affirmed, adopting the Tax Court's opinion as its own. 63 F.3d 1083 (11th Cir. 1995).
Supreme Court Opinions
A divided Supreme Court affirmed. Justice Kennedy, joined by Chief Justice Rehnquist and Justices Stevens and Ginsberg, authored the plurality opinion affirming the Eleventh Circuit's decision. The plurality rejected the IRS' argument that a fiduciary's discretion to charge expenses to income, or the actual payment of those expenses from income, disqualified the marital or charitable estate tax deductions or required an estate to reduce those deductions dollar for dollar. Instead, the plurality adopted a materiality test, determining that the Treasury Regulations, particularly 20.2056(b)-4(a), imposed special valuation rules on estate tax marital and charitable deductions.
The plurality concluded that payment of expenses from income, supported by either local law or the governing instrument, would reduce the charitable or marital deductions only upon a factual determination, presumably rendered after a fiduciary incurred and paid expenses, that the income charge was "material" when compared to the "date-of-death value of the expected future income." Once an estate reached the materiality threshold, it would be required to reduce the amount of the marital or charitable deduction to reflect the future obligation to pay those expenses. The plurality found this consistent with its interpretation of the same regulation in United States v. Stapf, 84 S. Ct. 248 (1963), which involved an offsetting, quid pro quo bequest to a spouse.
The IRS also argued, apparently for the first time to the Supreme Court, that to hold for the estate would result in receipt of a "double deduction." Under Code 642(g), an estate may deduct administration expenses on its estate tax return or its income tax return, but not on both. According to the IRS, unless a fiduciary reduces the marital deduction for the amount of expenses charged to income from marital deduction assets and deducted for income tax purposes, the estate would receive an income tax deduction and an "inflated" marital deduction. The plurality, however, dismissed the IRS' double deduction argument as meritless on the theory that the value of the marital deduction reported on the federal estate tax return does not include income on those assets.
Justice O'Connor, joined by Justices Souter and Thomas, agreed with the majority's holding but seemed unpersuaded that the charges to income in Hubert were not material. Without articulating objective criteria other than reference to a "de minimis" rule, Justice O'Connor criticized the IRS for limiting its argument and evidence to the dollar-for-dollar reduction position in a case in which the IRS had the burden of proof. Justice O'Connor concluded that, with no evidence in the lower court record of the date of death value of the future expenses charged to income, and no basis to analyze the IRS' case in view of the Court's standard, the estate won by default. Justice O'Connor observed that the IRS could cure the entire problem in its favor by amending the existing regulations. Neither affirming opinion saw the holding as violating Code 642(g), which only allows a fiduciary to deduct administration expenses one time, either on the estate tax return under Code 2053 or on the fiduciary income tax return.
When Can an Estate Qualify for a "Hubert" Deduction?
Suppose one assumes that the IRS does not follow Justice O'Connor's suggestion that the IRS fix Treas. Reg. 20.2056(b)-4(a). Further assume that the IRS requires a fiduciary to prove or disprove the "materiality" of expenses charged to income. How can the fiduciary charge administration expenses to accounting income and not reduce the marital or charitable deductions for federal estate tax purposes, thereby realizing the benefits of Hubert?
The unlimited Hubert deduction is possible only with authority under local law or governing instruments to charge expenses of estate administration to accounting income. An article of faith, assumed by all of the courts considering the Hubert case, was that Georgia law authorized the executors, in their discretion, to charge estate administration expenses against the estate's accounting income. A fiduciary, however, cannot necessarily assume that this authority is available.
The IRS originally issued its regulations under Code 2056 in 1958. Many states had no principal and income act in 1958, and few of those that did gave fiduciaries broad dis-cretion, regardless of the will or trust instrument, to pay death related administration expenses from income. For example, the Illinois Principal and Income Act did not expressly address the issue until the 1982 revision; indeed, it is unclear even now under the Illinois act whether a will can give an executor discretion to pay administration expenses from income, although a trust instrument probably can. The IRS prepared the marital deduction regulations at a time when most practitioners, and almost certainly all IRS personnel, assumed that estate administration expenses (as opposed to ongoing administration expenses) would be charged to principal. A cursory review of existing principal and income acts, many of which are based on the Uniform Principal and Income Act, shows that the statutes require fiduciaries to charge administration expenses to principal when there is no contrary provision in the governing instrument.
The first step for lawyers in planning after Hubert is to thoroughly review the applicable governing principal and income act. Many such acts contain no specific authority to pay estate administration expenses from income, but instead only offer fidu-ciaries broad discretion to apportion expenses between principal and income. Broad discretion to apportion expenses does not necessarily equal exoneration from liability, so fiduciaries should take care in exercising this discretion. Lawyers should give fiduciaries with this discretion appropriate guidelines and consider including provision in wills and trusts exonerating fiduciaries for their decisions on this matter.
Consider, for instance, a marital trust that gives the trustee limited discretion to pay principal to the spouse. The spouse may object to reducing his or her income by payment of significant administration expenses from income, even if it results in an income tax deduction. The maximum income tax benefit is only about 40%. Thus, the spouse will lose 60% of the expense dollars allocated to income, even if he or she receives all net income from the trust and therefore receives the benefit of the income tax deduction. The spouse may not believe that the increased amount of his or her marital trust and the income tax benefit are sufficient compensation for an immediate loss of income. Under Hubert, if the fiduciary lacks discretion under local law to pay expenses of administration from income or principal, the marital or charitable deduction will be reduced by estate administration expenses.
To the extent that a fiduciary charges expenses against principal, the fiduciary must reduce the marital or charitable deduction by the amount of the expenses charged against principal otherwise allocable to the marital or charitable shares. When a fiduciary pays administration expenses from principal and does not claim them as an estate tax deduction under Code 2053, and the governing instrument has a formula designed to obtain the optimum marital deduction while preserving the decedent's unused unified credit, the expenses will reduce or eliminate the available unified credit, thus reducing or eliminating the credit shelter trust.
If state law gives a fiduciary discretion to pay expenses of administration from income or principal only when allowed by the will or trust, or denies the discretion only if contrary to the provisions of the will or trust, the fiduciary must then look to the will or trust for authority. Very few wills and trusts drafted before Hubert and related cases give the fiduciary authority to pay expenses of administration from income. Therefore, at best, the will or trust will be silent on the subject or, at worst, require the fiduciary to charge administration expenses to principal.
Even if a fiduciary has the power to charge expenses of administration to income, Hubert offers very little guidance to the fiduciary for determining the value of the expenses and the spouse's income rights to be affected by the charges. Implicit in the Court's holding is that the fiduciary cannot determine materiality until the fiduciary actually incurs and pays the expenses, which is when the fiduciary can determine the total amount chargeable. The record in Hubert contained little evidence on this subject, so the opinions provide little guidance on where the threshold lies. Applying the proposed "materiality" rule offered by the plurality seems entirely relative and strictly a matter of context. The figures in Hubert were $500,000 of expenses charged to principal, with $1.5 million charged to income. Income during the first five years of administration totaled almost $5 million. Only the four justices in the plurality viewed charges of approximately one-third of the first five years' income as potentially immaterial.
One thing seems clear from the holding: the comparison of the value of the expenses actually charged to income to the value of the income rights passing to the spouse (or charity) is a double-present-value computation based on actuarial assumptions for the income interest. The date of death present value of the future obligation to pay the expenses that the fiduciary ultimately charges to income must be compared to the present value on the date of death of the spouse's right to receive the income. Both present values will be computed under the IRS' actuarial tables. Note that the tables treat older surviving spouses as receiving less valuable income rights because of their shorter life expectancies. Therefore, fiduciaries should exercise their discretion cautiously in cases with older spouses because any expenses charged to income will be an inherently larger burden on the surviving spouse's right to income. A fiduciary may derive only slight comfort from the hypothetical examples proposed by the plurality as material:
- significant non-income pro- ducing assets given to the spouse so that "the income she could expect to receive from it would be quite small"; and
- gifts limited when the only rights received by the spouse are rights to income, as opposed to broader outright gifts or trusts that include discretionary principal.
The Court seemed confused by the valuation principles that apply to marital deduction gifts. After suggesting that a marital gift limited to income rights might be particularly susceptible to a finding of materiality if the fiduciary uses income to pay expenses, the Court discarded this argument in the case of the trusts established for Mr. Hubert's widow on the grounds that those trusts were valued for estate tax purposes "as being equivalent to a transfer of a fee." The Court seemed to conclude that even though the widow might actually receive only income, because the value of the gift for marital deduction purposes was computed on the underlying asset values, the materiality test might apply to the underlying asset values, which were significantly larger than the value of the income rights.
Even with this conclusion, the issue will be whether the potential income charges would be a "material" charge against the spouse's income rights. If the charge is not material, the fiduciary can charge the expenses to income without consequence. If the charge is material, the fiduciary must engage in a second valuation exercise to determine the "net" value of the marital deduction under Treas. Reg.
20.2056(d)-4(a). To do so, the fiduciary must somehow reduce the value of the marital deduction by the pres- ent value of the obligation to pay the future expenses. Hubert leaves open the question of how a fiduciary should make the adjustment. The only certain principle is that the fiduciary need not make a dollar-for-dollar reduction of the actual amount of expenses charged to income. The only clue the plurality gave as to the adjustment, however, was its suggestion that the value of the marital deduction must "reflect" the date of death value of the expected future administration expenses chargeable to income. Subtracting the present value of the anticipated expenses to be charged to income would be a conservative approach, with any other approach inviting considerable scrutiny.
An examination of the materiality issue uncovers the irony of Hubert: the only cases for which the strategy is significant enough to bother with are those in which a finding of materiality is most likely. The $1-5 million estates will be the most perplexing because many of these generate administration expenses as significant as much larger estates, but the value of the surviving spouses' income rights, unless those spouses are very young, will be much lower. Small expense allocations invite scrutiny in these cases in which the administrative cost of valuation and defense are likely to outweigh the tax benefit. Yet these are the only relatively safe cases. In summary, the fiduciary must take the following steps to determine whether the estate can benefit from Hubert:
- determine the authority to charge administration expenses against income under the governing instrument or local law;
- compare the date of death value of the expected estate administration expenses to be charged to income against the actuarial value of the spouse's income interest in the marital deduction gift; and
- adjust the value of the marital deduction if the amount of the expenses to be charged appears "material" when compared to the actuarial value of the spouse's right to income.
Cautionary rules of thumb include not charging expenses to income when the spouse's rights are limited to income only or when the spouse is so elderly that his or her income interest has a small actuarial value.
The Hubert decision sheds some light on how the Code 642(g) election to deduct administration expenses on the estate tax or fiduciary income tax return affects the poten- tial deduction benefit sanctioned in Hubert. The Court rejected the IRS' argument that the executor's actions violated Code 642(g), although the Court seemed confused about the operation of this section. The 642(g) election is not an election to charge expenses either against principal or income for accounting purposes. Rather, the election is to deduct estate administration expenses (regardless of the source of payment) on one of two tax returns, the Form 706 Federal Estate Tax Return or the Form 1041 Federal Fiduciary Income Tax Return. Practitioners and the IRS historically assumed that expenses subject to this election would be charged against principal. The Court appears to believe that a fiduciary would charge all 642(g) elected expenses deducted on the income tax return to income, although this is not true.
Because of Hubert, it is now clear that allocating expenses to income does not violate Code 642(g) by creating a double deduction. In fact, a fiduciary's election to charge ex-penses to income is an election that the fiduciary may use in addition to the 642(g) election. Because the fiduciary may make the 642(g) election only on a fiduciary income tax return, and then only in time to claim those deductions before the statute of limitations expires for the return on which the fiduciary claims the deduction, the fiduciary should file a fee waiver at the last moment possible on any fiduciary income tax return on which the estate deducts 642(g) expenses. The fee waiver is a sworn statement about the 642(g) election, binding the fiduciary as to whether expenses are claimed against death taxes or income taxes. Waiting to file the fee waiver may require an amended return, filed several years after the original due date of the fiduciary income tax return at issue, but that is a small price to pay for keeping the option open as long as possible.
The expenses claimed under 642(g) on the fiduciary income tax return and charged to income may, on audit of the estate tax return, be found to be material. Thus, such charges may affect the estate tax charitable or marital deduction in a manner far greater than the income tax deduction available for those expenses on the fiduciary income tax return because of the higher estate tax rates. In those cases, a fiduciary may want to "reclaim" the deductions and, if the statute is still open, claim them on the estate tax return and abandon the deduction on the fiduciary income tax return. This would be impossible if the fiduciary had filed a fee waiver with the initial fiduciary income tax return.
Although the focus of Hubert was a potential double deduction for estate tax and fiduciary income tax purposes, the Hubert rationale is also useful in estates with unlimited marital deduction gifts coordinated to preserve the full $600,000 unified credit equivalent. A common estate plan involves using a formula to set up a credit shelter trust to hold the decedent's remaining unified credit exemption equivalent, usually $600,000, with a marital deduction gift of the balance. Hubert confirms that, when a fiduciary deducts expenses for income tax and not estate tax purposes under 642(g) and charges the expenses to principal, the expenses will reduce the marital deduction. Most formulas accordingly reduce the credit shelter trust by an equivalent amount to prevent incurring the estate tax that would occur because of the reduction in the marital deduction.
Hubert now allows a fiduciary to preserve the full $600,000 exemption equivalent gift by charging administration expenses, if authorized, to accounting income. In many of these cases, the expenses will not be material in any sense because significant estate tax work is not involved in most such estates. Although extraordinary litigation or burdensome administration in larger estates might still generate significant expenses, in no tax, unlimited marital deduction situations, there should be a correspondingly larger income interest in those cases so that charging expenses to income might still not be material. The result would be preservation of the full exemption equivalent amount while obtaining a current tax benefit for the administration expense deductions against the fiduciary income tax.
Hubert was not so much won by the taxpayer as lost by the IRS. The fact-based materiality test adopted by the Supreme Court requires a fiduciary to carefully scrutinize instruments and state law for authority to charge expenses of administration to accounting income. If that authority exists, the fiduciary can reduce income taxes and estate tax on the estate of the surviving spouse while preserving maximum use of the decedent's $600,000 unified credit exemption equivalent. Nevertheless, a fiduciary must use caution because guidelines are scarce, litigation is possible and those cases most at risk have the greatest potential benefit at stake.
David A. Baker is a partner with McDermott, Will & Emery in Chicago, Illinois.
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